Multinational Financial

Management
 What is the goal of MNCs?
• The goal of the managers of MNCs is to maximize the shareholders’ wealth…why?
• Since maximizing the shareholders’ wealth (by maximizing the market value
of the share) will satisfy the shareholders and subsequently raise capital to
finance the firms operations during later issuances.

• International financial management is important even to companies that have no

international business…Why?
• Purely domestic firms should be aware of all the economic conditions that
may affect their competitors of MNCs such as movement in exchange rate,
foreign interest rate, labor cost, and inflation, as these conditions affect
foreign competitors’ cost of production and pricing policies.
 Structure of MNCs

U.S Parent

Subsidiary in Egypt Subsidiary in Tokyo Subsidiary in France

 Problems that may arise?
• Managers of MNCs make decisions that conflict with the firm’s goal to
maximize the shareholders’ wealth -This conflict of interest is
known as Agency Problem.

• As a result, certain costs will be incurred to ensure managers

maximize shareholders’ wealth (or opportunity cost due to the
managers actions that contradicts with maximizing the shareholders’
wealth) Known as Agency Cost
 Agency Problem Exacerbated
• Agency problem is larger for MNCs that for purely domestic firms…
Why?
• Subsidiaries are scattered around the world, hence, monitoring managers of
distant subsidiaries in foreign countries is more difficult
• Foreign subsidiary managers raised in different cultures may not follow
uniform goals
• Larger MNCs are more susceptible to larger agency problems
• Non-U.S. managers tend to downplay the short-term effects of decisions.
 Managing the Agency Problem
• Two control methods can help alleviate the agency problem:
1. Parental Control
2. Corporate Control
 Parental Control of Agency Problem
• Use proper governance
• Clearly communicating the goals for each subsidiary
• Parent company can implement compensation plans that reward the
subsidiary managers who satisfy the MNC goals such as providing the
managers with stocks) known as “Managerial Compensation”
 Corporate Control of Agency Problem
• Poor decisions will reduce the value of the firm, hence, another firm
will be able to acquire it at a lower price and most likely remove weak
managers “Hostile Takeover”
• Institutional investors such as mutual funds and pension funds that
have large holdings of stocks can attempt to remove high level
managers and the Board of Directors overall “Proxy Fight”.
Common Methods to Improve Internal Control

• Establish a centralized database

• Ensure that all data is reported consistently among subsidiaries
• Implement a system that automatically checks data for unusual
discrepancies
• Speed the process by which all departments and subsidiaries have
access to data needed
• Make executives more accountable for financial statements by
personally verifying accuracy by the enactment of the Sarbanes-Oxley
Act
 Sarbanes-Oxley Act
• Sarbanes-Oxley Act improves the corporate governance of MNC.

• The reason of implementing the Sarbanes-Oxley Act is that managers may exaggerate the
performance, which is similar to what happened during the Financial Scandals period

• Sarbanes-Oxley Act ensures a more transparent financial reporting process and holds the
managers accountable

• Sarbanes-Oxley Act requires the firm to implement an internal reporting process that can be
easily monitored by executives and the BOD.

• These systems made it easier for a firm’s board members to monitor the financial reporting
process. Therefore, SOX reduced the likelihood that managers of a firm can manipulate the
reporting process and therefore improved the accuracy of financial information for existing
and prospective investors.
 Management Structure of the MNC
• The management structure impacts the magnitude of the agency
cost.

• There are two management structures:

• Centralized Management Structure
• Decentralized Management Structure
 Management Structures...Pros and Cons
Centralized Management Structure Decentralized Management Structure
• Managers of the parent company take control • Subsidiary managers who are most informed
of the subsidiary, hence, can reduce agency about the subsidiary make the decisions
costs • Subsidiary managers may make decisions that
• Reduce the power of the subsidiary managers conflict with maximizing the shareholders’
• Parent company's managers may make poor wealth
decisions, since they aren’t informed about • More likely to result in higher agency costs
the subsidiary as its managers

Blend both Trade-off between both

management styles
Implement a decentralized structure
while continuously communicating the
goals, giving compensation and
monitoring the decisions taken by the
managers
 How does the internet come in handy?
• The internet facilitates the management control by making it easier
for the parent to monitor the actions and the performance of its
subsidiaries
• Communicating by phone isn’t convenient and expensive
• Internet allows the use of e-mail and can easily track inventory, sales,
expenses and earnings of each subsidiary on a weekly, monthly basis,
…etc
Answers to End of Chapter Questions
1. Agency Problems of MNCs.
a. Explain the agency problem of MNCs.
ANSWER: The agency problem reflects a conflict of interests between decision-making
managers and the owners of the MNC. Agency costs occur in an effort to assure that managers
act in the best interest of the owners.

b. Why might agency costs be larger for an MNC than for a purely domestic firm?
ANSWER: The agency costs are normally larger for MNCs than purely domestic firms for the
following reasons. First, MNCs incur larger agency costs in monitoring managers of distant
foreign subsidiaries. Second, foreign subsidiary managers raised in different cultures may not
follow uniform goals. Third, the sheer size of the larger MNCs would also create large agency
problems.
 Why pursue international business?
• Theory of comparative advantage
• Imperfect markets theory The three theories overlap
and complement each other
• Product cycle theory in developing a rationale for
the evolution of
international business
 Theory of Comparative Advantage
• Specialization by countries can increase production efficiency.
• Therefore, better for a country to specialize in products that they have
comparative advantage in and use the revenue to import the products
that aren’t good at- Therefore, trade between countries is essential
 2. Imperfect markets theory

- The real world suffers from imperfect market conditions where

the mobility of production factors is restricted.

- Imperfect markets provide an incentive for firms to seek out

foreign opportunities.

- Restrictions on transfer of labor, other resources used for

production and restrictions on transferring funds and other
resources among countries.

17
Product Cycle Theory
 Answers to End of Chapter Questions
Explain how the theory of comparative advantage relates to the need for international business.
The theory of comparative advantage implies that countries should specialize in production, thereby relying on other countries for some
products. Consequently, there is a need for international business.

Explain how the product cycle theory relates to the growth of an MNC.
The product cycle theory suggests that at some point in time, the firm will attempt to capitalize on its perceived advantages in markets
other than where it was initially established.

Explain how the existence of imperfect markets has led to the establishment of subsidiaries in foreign markets.
Because of imperfect markets, resources cannot be easily and freely retrieved by the MNC. Consequently, the MNC must sometimes go
to the resources rather than retrieve resources (such as land, labor, etc.).

If perfect markets existed, would wages, prices, and interest rates among countries be more similar or less similar than under
conditions of imperfect markets? Why?
If perfect markets existed, resources would be more mobile and could therefore be transferred to those countries more willing to pay a
high price for them. As this occurred, shortages of resources in any particular country would decrease and the costs of such resources
would be similar across countries.
 How firms engage in international business
• International trade
• Licensing
• Franchising
• Joint ventures Risk and Return
• Acquisition of existing operations
• Establishing new foreign subsidiaries
 International Trade
• Conservative approach to penetrate markets and obtain supplies at a
low cost (exporting and importing)
• Return: conservative approach to penetrate foreign markets
• Risk: minimum risk as the firm doesn’t place any capital at risk and
can reduce imports and exports at anytime.
• The internet can facilitate the international trade by using the
websites to list their products, prices, advertise the products,
software to track purchases, shipments,…etc
 Licensing
• Obligates the firm to provide its technology (copyrights, patents,
trademarks, tradenames) in exchange for fees or some other specified
benefits (Licensing revenues is known as royalties)

• Return: allows firms to use their technology in foreign markets

without a major investment in foreign countries and without the
transportation costs that results from exporting.

• Risk: difficult for the firm providing the technology to ensure quality in
the foreign production process
 Franchising
• Obligates a firm to provide specialized sales or service strategy,
support assistance or an initial investment in the franchise in
exchange for periodic fees – provide the know how

• Return: allows firms to penetrate foreign markets without a major

investment in foreign countries

• Risk: Limited expansion in comparison to establishing foreign

subsidiaries and acquisition
 Joint Ventures
• Venture that is jointly owned and operated by 2 or more firms

• Return: penetrate a new market with firms that resides in those

markets and use their respective comparative advantages in a given
project

• Risk: Limited expansion in comparison to establishing foreign

subsidiaries and acquisition
 Full Acquisition of existing operations
• Firms acquire other firms in foreign countries to penetrate
foreign markets

• Return: penetrate foreign markets and firms will have full

control over their foreign businesses and quickly obtain a
large portion of foreign market share

• Risks: subject to large losses because of the large

investment required. Also, if foreign operations performs
poorly, the firm may achieve losses.
 Partial Acquisition of existing operations
• Firms engage in partial international acquisition

• Return: firms engage in partial international acquisition to obtain a

stake in foreign operations while using a smaller investment and less
risk

• Risk: firm has no complete control over foreign operations

 Establishing a new foreign subsidiaries
• Return: the firm operates in foreign markets, may be preferred to
foreign acquisitions because the operations can be tailored exactly
according to the firms needs, also smaller investment needed than to
purchase existing operations

• Risk: large investment needed, firms will not reap any rewards from
the investment until the subsidiary is built and the customer base is
established.
 Summary
• International business that requires a direct investment in foreign operations
normally is referred to as direct foreign investment (DFI)

• International trade and licensing are usually not considered DFI, since no direct
investments in foreign operations

• Franchising and joint ventures tend to require some investment in foreign

operations but to a limited degree

• Foreign acquisitions and establishment of new subsidiary represent the largest

portion of DFI
Answers to End of Chapter Questions
Do you think the acquisition of a foreign firm or licensing will result in greater growth for an MNC? Which
alternative is likely to have more risk?
An acquisition will typically result in greater growth, but it is more risky because it normally requires a larger
investment and the decision can not be easily reversed once the acquisition is made.

Describe a scenario in which the size of a corporation is not affected by access to international opportunities.
Some firms may avoid opportunities because they lack knowledge about foreign markets or expect that the risks
are excessive. Thus, the size of these firms is not affected by the opportunities.

Explain why MNCs such as Coca Cola and PepsiCo, Inc., still have numerous opportunities for international
expansion.
Coca Cola and PepsiCo still have new international opportunities because countries are at various stages of
development. Some countries have just recently opened their borders to MNCs. Many of these countries do not
offer sufficient food or drink products to their consumers.
 MNCs Valuation
MNCs Cash Outflow MNCs Cash Inflow
• Pay for imports • Revenue from exports

• Comply with international • Fees from the services it provides

agreements within international agreements

• Support the creation or • Remitted funds from the foreign

subsidiary
expansion of foreign subsidiary
 Valuation Model for MNC
• Need to know the maximum amount to be paid today
• Present Value = Cashflow in domestic currency + Cashflow from
subsidiaries in $
• Present Value = Cashflow in domestic currency + (Cashflow from
subsidiaries * Exchange Rate ($ per unit of foreign currency)
• Factors that affect the time value of money are expected cashflow and
the minimum required rate of return
• The rate of return compensate for the risks such as social risks, economic
conditions, political risks (all is reflected in the exchange rate)*
• Present Value =
 Example
• XYZ Co. has expected cash flows of $1,000,000 from local business and 10 million
Mexican Pesos from business in Mexico at the end of the year, assuming that the
Mexican’s value is expected to be $ 0.052, and the required rate of return is 12%.

a. Evaluate the expected dollar cash flows of this company.

Expected Future Cash Flows = $1,000,000 + (10,000,000*$0.052) = $1,520,000

Value of the firm = $1,520,000/(1+12%)= $1,357142.86.
Answers to End of Chapter Questions
Plak Co. of Chicago has several European subsidiaries that remit earnings to it each year. Explain how
appreciation of the euro (the currency used in many European countries) would affect Plak’s valuation.
Plak’s valuation should increase because the appreciation of the euro will increase the dollar value of the cash
flows remitted by the European subsidiaries.

As an overall review of this chapter, identify possible reasons for growth in international business. Then,
list the various disadvantages that may discourage international business.
Growth in international business can be stimulated by (1) access to foreign resources which can reduce costs, or
(2) access to foreign markets which boost revenues. Yet, international business is subject to risks of exchange
rate fluctuations, and political risk (such as a possible host government takeover, tax regulations, etc.).
Answers to End of Chapter Questions
Hudson Co., a U.S. firm, has a subsidiary in Mexico, where political risk has recently increased. Hudson’s
best guess of its future peso cash flows to be received has not changed. However, its valuation has declined
as a result of the increase in political risk. Explain.
The valuation of the MNC is the present value of expected cash flows. The increase in risk results in a higher
expected return, which reduces the present value of the expected future cash flows.

Would the agency problem be more pronounced for Berkley Corp., which has its parent company make
most major decisions for its foreign subsidiaries, or Oakland Corp., which uses a decentralized approach?
The agency problem would be more pronounced for Oakland because of a higher probability that subsidiary
decisions would conflict with the parent. Assuming that the parent attempts to maximize shareholder wealth,
decisions by the parent should be compatible with shareholder objectives. If the subsidiaries made their own
decisions, the agency costs would be higher since the parent would need to monitor the subsidiaries to assure
that their decisions were intended to maximize shareholder wealth.
Answers to End of Chapter Questions
Explain why political risk may discourage international business.
Political risk increases the rate of return required to invest in foreign projects. Some foreign projects would have
been feasible if there was no political risk, but will not be feasible because of political risk. Also, a foreign
government may increase taxes or impose barriers on the MNC’s subsidiary. Alternatively, consumers in a
foreign country may boycott the MNC if there is friction between the government of their country and the
MNC’s home country.

SOLVE QUESTIONS 13, 14, 15, 16 FROM THE BOOK